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Simple Interest

Simple interest is paid on the principal amount borrowed and is not compounded.

Definition

Simple interest is interest that is paid on the principal amount borrowed. It is considered the best type of interest for a borrower because it is not compounded.

Simple Interest Explained

Borrowing money comes with a fee from the lender. Interest is that cost, and it comes in two forms: Simple and compound.

Simple Interest

Simple interest is considered the best form of interest for the borrower because it is charged only once, and is a percentage of the original principal, unlike compound interest. If you borrow $1,000 at 10 percent simple annual interest, then you pay $100 in interest per year. If you borrow it for two years, then you pay $200 in interest. This is different than the more common compound interest.

Compound Interest

Compound interest is based not only on the original sum, but also on accrued interest. For example, many credit cards charge compound interest monthly. If you borrow $1,000 with a simple annual interest rate of 12 percent, you pay less in interest than if you borrow that same amount with a compound interest rate of 1 percent per month. If the loan with the simple interest is paid off at the end of the year, the total amount in interest paid is $120. However, with the compound interest, it costs $126.83. The reason is that, unlike simple interest, compound interest builds upon itself every month. Although the difference is only $6.83 in the above example, most people see a far more dramatic difference. Since most credit cards have compound interest instead of simple interest and many people pay only the minimum amount on their credit card payments, the interest adds up very quickly.

Which is Better?

Because of their fixed costs, loans with simple interest are preferable than those with compound interest.

Video: Calculating Simple Interest

In this video, InspireMath shares the equation, along with examples, for calculating simple interest.